When NOT to put money in your 401(k)

Photo: Philip Brewer

The twin advantages of tax deferral and a corporate match make the 401(k) the foundation of most people's savings plan. Putting in enough to get the maximum corporate match is almost always the right choice--a good corporate match is so much money, funding your 401(k) usually even comes ahead of paying off debt. Sometimes, though, it makes sense to put money other places.

Here's a quick ordering that makes sense for a wide range of financial situations, followed by a look at some special situations that can influence your choices. Of course, all this is after you've housed, clothed, and fed your family, and paid your bills.

Minimum payments on debts. It would be dumb to ruin your credit while putting away money for retirement.

401(k) to the limit of the corporate match. The only time you wouldn't go for the full match would be if the match were lousy or you had debt at really high interest rates. If the corporate match is 50% but your payday loan is costing you 56%, then pay off the payday loan. If it's going to take more than a year to pay off your debt, then you have to do some arithmetic to compare the interest rates, because you only get the match in the first year. If, for example, you're going to be paying off debt for three years, and your corporate match is 100%, then you'd want to pay off any debt where the interest rate is over about 33% before you started funding your 401(k).

Accelerated payments on debts. Once you're grabbing the full corporate match, go ahead and apply additional money to paying off debt. The exception would be debts with low, fixed interest rates (mortgages and student loans often fall into this category).

A Roth IRA. If you're getting the full corporate match on the 401(k) and you still have some money available to invest, I'd put it into a Roth IRA. You don't get a tax deferral, but your earnings are tax-free forever. The earlier you start maxing out your Roth, the more earnings you'll have that you never have to pay taxes on. Go ahead and max out your spouse's Roth IRA as well.

Up to this point, it's really pretty straightforward--those choices are right for the vast majority of people. If you've made it to this point, though, and you've still got some money to invest, you've got a real decision to make.

Conventional wisdom at this point would be to max out your 401(k)--bring your contributions up to the maximum your employer allows. (There's also an IRS limit.) Depending on your tax situation and your plans for the future, though, I'd like to suggest an alternative: regular savings and investments.

The advantage of maxing out the 401(k)--tax-sheltering that much more of your current income--are clear. But you've already deferred a bunch of taxes, plus you've arranged for some permanently tax-free earnings. Whether tax-sheltering further income makes sense is worth considering carefully.

First, does tax-deferral make sense? Only if your future tax rates will be lower than your current tax rates. Tax rates now are about as low as they've been for a long time. I think there's a significant chance that tax rates in the future will be higher--enough of a chance that, with a portion of your savings, I think it's perfectly reasonable to pay taxes now, at the current rates, rather than pay it later at whatever the rates will turn out to be.

Second, when are you going to want the money? Even though it's possible to borrow money from a 401(k), if there's any significant chance that you'll want the money before retirement, you're probably better off keeping the money out of any of these tax-deferred plans. So, if you're saving for a new car or a new house or any other major purchase, it can make sense to just invest the money in an internet savings account, short-term bond fund, or some other reasonably liquid investment with a time horizon that matches when you're going to want the money.

In particular, if you're saving with a plan to retire early (before age 59), you probably want to accumulate significant savings outside of a retirement account.

It's possible to tap an IRA before age 59½. It's even a reasonable thing to do, if you're actually retiring. You have to follow some complicated rules whereby you take out money at a rate that will make the account last the rest of your life, according to the IRS estimate of your life expectancy. Once you start, you have to continue for at least 5 years. If you take out the wrong amount, then all the withdrawals turn into early withdrawals and you have to pay the 10% penalty. And, even if you follow all the rules, it's still income that you need to pay taxes on.

I think it's perfectly reasonable, once you've tax sheltered a goodly sum, to just pay the taxes on the rest of your income now, invest, and then own it with no deferred tax liability in the future.

Remember that your money is fungible, so the goals that you have for your money shouldn't be influenced by the names of the compartments where you keep it. Money in a retirement account supports all your financial goals, as does money in a brokerage account, a college savings plan for your kids, etc. If you're putting money into a 529 plan before you're getting the full employer match on your 401(k), you're not increasing the chance that your kids will be able to go to college, you're just making your whole family's financial future less secure. All your investments support all your financial goals. Chose the compartments you keep the money in to maximize your total savings after-tax; don't be distracted by what the plans are called.

An additional reason that I suggest using a mix of 401(k), Roth IRA, regular IRA, and plain old after-tax savings and investments, is that the government can change the rules on these tax-favored plans at any time. There are so many voters in each of these plans now that it would probably be political suicide to try to eliminate them, but politicians always want to get their hands on any money that they can. Between now and when you retire, there very well might be a point where a political consensus emerges that some crisis is so severe as to make people's retirement savings fair game. Best if your money is spread around a bit, so that you're less likely to get bit with the full force of whatever money grabbing the politicians end up with, since they're liable to grab at different plans differently.

Of course, one big win of a 401(k) is that you definitely do save the money. If there's any chance that some of that extra savings won't actually get saved if it doesn't go into the 401(k), then stick with the 401(k). The tax saving of a 401(k), together with the option to borrow money from the plan, means that it's never going to be the wrong choice for saving. The reasons to go ahead and save some money outside the plan are real enough under some circumstances (if you're going to use the money before retirement, and especially if you're already paying taxes at a fairly low rate), but they're small. It matters far more that you actually save the money than it does where the money gets saved.

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Guest's picture

Excellent post, demonstrating the way we need to look at and evaluate all important financial decisions.

Keep the asskicking posts coming!

Guest's picture

One reason i'm not taking advantage of my company's 401k plan is that their match is pretty low, and what they do match I have to be "fully vested" (employed for the full 4 years) in order to take with me. I'm not planning to be at the company this long, so it seemed like a very small return in the end. Any thoughts?

Nora Dunn's picture

Great post as usual, Philip!
Diversification is the key, and having your entire portfolio in a 401k can be risky for all the reasons you mentioned here.

@Sara: my humble thoughts are that if you were to make the contribution to the 401k anyway, then go ahead. But if that money according to Philip's list might be better used elsewhere, and you're not getting the company match, then maybe you're on the right track with your thinking.

The one advantage of contributing through an employer (company match or not), is the immediate tax relief. If I'm not mistaken (at least it works this way in Canada), your contribution would come off your gross pay, and you effectively get your tax refund right away. $100 contributed through work off your gross pay leaves you with more on your net paystub and in your pocket than if you contributed $100 from your net pay and waited for the refund to come.

Not to step on your toes, Philip - just my two frugal cents. Thoughts?  

Guest's picture

Great post, linked!

Guest's picture

Another plus for the Roth IRA is your original contributions can be withdrawn at any point with no penalty. A lot of people forget this fact when deciding whether or not to contribute.

Philip Brewer's picture

As Nora points out, you still get the tax deferral with a 401(k) contribution, even if the match is poor. If there were no match, I'd put the 401(k) roughly equal with the Roth IRA, depending on your tax situation. It's not too hard to figure out what you'd save in taxes by putting the money in the 401(k), so do a quick calculation and see.

Also, remember that many people who don't plan to stay in a job for 4 years nevertheless find themselves there after all. I wouldn't completely discount the match, unless your plans to leave are quite definite

@FlatGreg--thanks much for the observation on withdrawing the original contribution to a Roth. That makes it a great place to put money for any kind of long-term goal, not just retirement.

Guest's picture


Outstanding article. That's some thorough writing (and thinking)!

One other time when you should pay down debt instead of investing in your 401(k) is if you're thinking of buying a house. Lenders look carefully at your debt to income ratio, and it affects both your interest rate and the amount you can borrow.

If you're thinking about buying a house in the future, it might (temporarily) be a smart idea to start paying down any high interest debt or debt with high utilization ratios. You'll increase your credit score, improve your debt to income ratio, and potentially save yourself a lot of money over the long-term with a better interest rate.

Thanks for the article!


Guest's picture

Another reason to max out the 401K is it lowers your AGI. If you're on the verge of getting phased out of your Roth IRA because you're close to the income limit, putting more money into the 401K can keep you eligible. Same goes for tuition credits, which you can only get if your AGI is below certain limits.

Guest's picture

Can 401k contribtutions also help when you are getting close to the alternate minimum tax limits?

Philip Brewer's picture

I'm no tax expert, but it looks to me like 401(k) contributions do work to reduce your income, making you less likely to be subject to the AMT. If you're on the edge between having to pay the AMT and not, that would be a strong reason to prefer your 401(k) over other saving and investing options. You'd want to do your own research, though, or consult a tax expert, before taking steps with that goal in mind.

Nora Dunn's picture
Nora Dunn

As Jon Morrow points out, qualifying for loans like mortgages can be affected by the debt to income ratio.

Also, you can't usually use retirement savings plans (if I'm not mistaken) as collateral to borrow against in the case of applying for a loan of sorts, be it a mortgage or major loan for a second piece of land or a vehicle.

Just another case for having some assets outside of 401ks and Roth IRAs.  

Philip Brewer's picture

Thanks, Nora. Yes, that's my main point: you need to balance all these things.

A corporate match on your 401(k) contributions is often so large as to just swamp the other issues. But once you're getting the full corporate match, there are a lot of issues, large and small, that you need to balance, when deciding how much to tax shelter versus how much to invest without sheltering. I tried to cover the key ones in my piece. Several others have been mentioned in the comments above. (Thanks guys!)

Guest's picture

I've asked elsewhere, but never received a clear answer. Neither me nor my wife have a Roth IRA today, but are planning to start one by the end of this year. Can we BOTH start one each, or since we file our income taxes jointly does that compel us to start one joint Roth IRA?

From the Wikipedia's list of limits:


* Single filers: Up to $99,000 (to qualify for a full contribution); $99,000-$114,000 (to be eligible for a partial contribution)
* Joint filers: Up to $156,000 (to qualify for a full contribution); $156,000-$166,000 (to be eligible for a partial contribution)
* Married filing separately (if the couple lived together for any part of the year): $0 (to qualify for a full contribution); $0-$10,000 (to be eligible for a partial contribution).

Since both of us earn money, that third bullet seems to exclude the option of two separate IRAs...

Philip Brewer's picture

Again, I'm no tax expert. However, I'm pretty sure that IRAs of all types are per-person. You not only don't need to open a single Roth IRA for the two of you, I'm pretty sure that you can't--the IRA needs to be for a specific person (whose age will be the one that determines when you can take money out without penalty, etc.).

The contribution limits vary depending on your filing status, but if you both qualify, you can both open a Roth.

Guest's picture


im in my early twenties and im in the first job in my life that i see myself working for a long time. They opened enrollement for 401k since ive been here a year. I have never read anything about 401k other than it is a good savings plan for the future. I have many questions like if i should sign up for it. i earn around 2200/mo not counting bonuses. how much do you think i should set aside for 401k or a savings avenue (counting i do rent an apt and have car payment)?

Philip Brewer's picture

If the plan has a match, and you can afford it, put in enough to get the whole match.  (Lots of plans will match what you put in, up to the first 3% or 6% of your salary, at 50 cents or even 100 cents on the dollar).

Generally, a match is such a good deal (free money) that it almost doesn't matter what your financial circumstances are--pick up the match if you can.

After that, it gets a bit more complicated.  Money that you put into a 401(k) is tax deferred--you don't pay taxes on the money this year (the year that you earned the money).  Instead, you pay regular income taxes the year that you take the money out.  That makes it impossible to know for sure what the best thing to do is, without knowing the future.

Guest's picture

Nice Thoughts, but your 401k and any kind of pension will be dissolved by health insurance. All that money you saved will be gone! Just to keep you alive. You will be supporting people that you don't even know. So long capitalism hello communism!